New Model of Blockchain Capitalism

ICOs are the hot new thing in the Blockchain community. The idea behind an initial coin offering is that a company promises to build a Blockchain-based product or service.

To raise the funds necessary to the execution of its roadmap, the company issues digital tokens and sells them to contributors, usually all at once.

Contributors can then use these tokens to run the service when it is up and running, hold them or sell them for profit.

More and more Blockchain startups are organizing token sales as a way to raise money upfront in ICOs, a nod to the traditional securities’ IPOs. When last year, these companies raised $260 mln according to the research firm Smith + Crown, they have already raised over $560 mln since the beginning of 2017.

ICOs are considered an alternative to crowdfunding and are transforming the way startups capitalize themselves. It’s basically a way for Blockchain startups to raise money outside the accredited system.

While tokens operate in the same way equity stakes do, they cannot be considered the same. Indeed, for securities to be sold, they need to be registered with the Securities and Exchange Commission. That is absolutely not the case for tokens, which are more like licenses people use to access a particular application on the Blockchain.

Breaking records

In 2013, Mastercoin organized a token sale to raise funds and was one of the first projects to use this new type of capitalization. Despite warnings that Mastercoin might just be an elaborate scam, investors braved the risk and contributed what was the equivalent of $500,000 at the time.

Ethereum followed the trend in 2014 and managed to raise $18 mln, although the project lost millions after the Bitcoin price crash that year. From there, ICOs started breaking records little by little, until a decentralized venture capital firm entered history by raising $150 mln in 2016. This firm is the infamous The DAO, which was hacked shortly after and lost $50 mln.

Since these ICOs are not regulated by the SEC, nothing can be done by authorities after such events. Startups that issue tokens become self-regulating entities that are independent of third parties, but contributors cannot be guaranteed that the roadmap promised by the founders will be respected. This dubious legal status makes ICOs a particularly risky investment.

No rules

The SEC is currently examining this capitalization method but until something is decided, contributors cannot enjoy any protection on their investment.

Aaron Ting, VP of the Malaysian Investors’ Association, believes:

“It is an investment option for those who have a high risk, high reward appetite.”

“Even though the white paper claims that by purchasing ICO tokens, investors own part of the start-ups’ assets and liabilities and have a claim on its profit, there is nothing much you can do if the project does not materialise and the people behind it take your money and run. There are no rules and regulations to govern the space,” explains Matthew Tan, founder and CEO of Etherscan.

Risk appetite

By examining the developments of previously ICO-funded startups, one can argue that not many can be categorized as complete projects today. There is no doubt more time is needed to grow into a successful global company, but big wins in this field could bring more confidence to investors.

Adding to the difficulty of the exercise, it is not easy to distinguish between the genuine projects and the scams. For this reason, industry experts insist that contributors do their due diligence before investing and get deeply familiar with the project founders, its realizability and its potential for mass usage.

Robin Lee, founder and CEO of Hello Gold, recalls:

“It’s like during the Internet boom. You couldn’t really tell that Google, Amazon and Apple would turn out to be the big winners they are today. The potential of the technology is huge, but it is very hard to tell who will create the great success at the end of the day. It is still in the early stages.”

Moreover, projects funded through ICOs later face numerous risks. Pump-and-dump is a form of microcap stock fraud that involves artificially inflating the price of an owned stock through false and misleading positive statements, in order to sell the cheaply purchased stock at a higher price. Such tactics are not uncommon on cryptocurrency exchanges as the market is not regulated.

There is also the possibility of cyber attacks on projects to cause token prices to plunge and benefit from it, especially from hackers using margin trading to amplify their returns at the expense of others.

New model

Despite all the risks ICOs engage, they are particularly fit to raise large sums while cutting out third parties. Instead of sharing revenues with traditional venture capital firms, startups can now reward their early adopters and first ones to believe in their project.

Matt Levine, a Bloomberg View columnist, explains:

“The company and the customers are necessary components to the system; the investor, in the new model of blockchain capitalism, is just an interloper, and can be dispensed with.”

From this perspective, tokens are used by customers to receive a service and are not sold to a handful of institutional investors that only bought them to profit from the future growth of the company. The ICO phenomenon evidences the need for freedom to invest outside the accredited system. The Blockchain ecosystem is even auto-regulating bad practices in the field.

“While the ICO arena has had its fair share of outright scams, pump and dumps, and blatant Ponzi schemes, much of the criminal activity is now being mitigated by self-organized, crowdsourced due diligence in the community, as well as by external parties such as Smith and Crown and ICO Rating,” details Richard Kastelein, founder of Blockchain Partners.

Just as venture capital firms are taking a hard look at this wild west of financing, so should we all. It’s not just about the money that can be made, but also the emergence of a new model of Blockchain capitalism that has the potential to fund not only Blockchain projects but also startups and even networks in the near future.